QUICK SUMMARY

This report will help policymakers prepare for the next economic downturn by explaining the ways states can design their rainy day funds to harness fluctuations in revenue. The Pew Charitable Trusts reviews the rules that guide when, how, and how much states are saving—including deposit rules and fund caps—and compares these policies with each state’s experience with volatility to identify best practices. This report is the second in a series that provides policymakers with strategies to improve long-term fiscal health and manage budget uncertainty, building on “Managing Uncertainty: How State Budgeting Can Smooth Revenue Volatility,” which examined patterns of revenue and economic volatility across the 50 states.

Key Findings

States had about half the reserves necessary to address budget gaps during the first year of the Great Recession. The 50 states had about $60 billion set aside in the summer of 2008, but in fiscal 2009, budget gaps across the country totaled $117 billion, about twice what states had in reserve. The budget gaps continued to grow in 2010 and many states struggled with shortfalls for three or more years.

Only a dozen states link the rules for when, how, and how much to deposit into their budget stabilization funds with underlying revenue or economic fluctuation. By linking savings to volatility, states can take advantage of revenue increases while ensuring a greater level of budget flexibility in the future.
Pew identified several promising practices across 12 states that require deposits into a budget stabilization fund when the state experiences unusual or above-average revenue or economic growth. Of the 12 states, five tie deposits to overall revenue volatility; four use a specifically volatile revenue source; and three link savings to economic volatility. As a group, these states are no more or less volatile than their peers.
Thirty-eight states do not have rules that tie rainy day deposits to underlying economic or revenue conditions. Of these, 21 states use year-end fiscal positions (i.e., their balances at the end of the fiscal year) to guide deposit decisions, five use forecast error—the difference between actual and projected revenue—eight make deposits on an ad-hoc basis or based on static requirements, and four do not have a budget stabilization fund.

37
states set fixed caps for their rainy day funds – preventing them from saving enough to weather recessions.

In many instances, caps on the size of rainy day funds have prevented states from saving enough to substantially offset revenue losses. Although most states recognize the importance of having a fund to smooth the booms and busts of the revenue cycle, few base the size of their rainy day fund on their own typical revenue fluctuations.
Before the Great Recession, 37 states set caps using a fixed percentage of appropriations or revenue. Many states saved up to their funds’ maximum balances in the years before the Great Recession, and often, these caps prevented them from saving enough to weather the crisis. Budget gaps during the Great Recession led some states, including Minnesota and Virginia, to reexamine and raise their caps.

OVERVIEW

Over the past several decades, rainy day funds—formally known as budget stabilization funds—have been key to helping states manage ups and downs in revenue, but some are more effective than others. In many cases, balances have been inadequate to significantly offset revenue declines during recessions. For example, the 50 states collectively had about $60 billion set aside in summer 2008,1 but they faced a combined shortfall of nearly twice that—$117 billion—the following year.2 The Great Recession is an extreme example, but many rainy day funds were also insufficient during previous recessions. States could have set aside more in recent periods of growth if not for statutory limits on the total size of reserves and rules for deposits that make saving a low budget priority.

To help state policymakers craft effective policies and lessen the need for the most difficult budget choices, Pew researchers examined the mechanisms for depositing money into budget stabilization funds and compared these rules to tax volatility patterns and drivers in all 50 states. Researchers adjusted U.S. Census Bureau data to remove the effect of tax policy changes from 1994 to 2012, which helps to identify the underlying cyclical volatility in these tax sources. The research found that:

Only 12 states connect the rules for when, how, and how much to deposit into their budget stabilization funds with underlying revenue or economic fluctuation.

In many instances, caps on the size of the funds have prevented states from saving ­enough to substantially offset revenue losses.

RECOMMENDATIONS

Pew’s research identified three promising practices that can help state policymakers design budget stabilization funds that respond to economic and revenue volatility in order to deliver reliable savings in times of growth:

Require regular studies to identify major sources of volatility and present appropriate policy solutions. These studies should determine which areas of the tax system are volatile, recommend ways to align budget stabilization fund policies with that volatility, and be revisited on a recurring basis.

Tie budget stabilization fund deposits to observed volatility. To ensure that policymakers set aside a portion of one-time or temporary revenue growth, rainy day fund deposits should be tied to extraordinary or unexpected revenue increases. This can allow states to save more in high-growth years, when funds are available, and to set aside less in leaner years. Because each state’s economic and fiscal characteristics are unique, the ideal rule will vary from state to state.

Set fund size targets that match the state’s experience with volatility. The amount of money states need to have on hand for downturns depends on their susceptibility to sudden swings. Even when deposits are linked to volatility, if the fund’s cap is too low, it can hinder creation of an adequate financial cushion.

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